Well, another year of blogging is over.

For me, it was a year of research themes. I spent the first half of 2023 debunking interest-rate orthodoxy. Then I spent the second half of the year studying the world’s billionaires. Here were the top 5 posts:

1. Do High Interest Rates Reduce Inflation? A Test of Monetary Faith
2. How Interest Rates Redistribute Income
3. Interest Rates and Inflation: Knives Out
4. Mapping the Ownership Network of Canada’s Billionaire Families
5. Interest Rates and Unemployment: An Underwhelming Relation

A big thanks to my blog patrons, who’ve made it possible for me to do economic research outside of academia. If you’d like to support my work, you can do so here:

Thanks for reading,

Blair

The post Top Posts of 2023 appeared first on Economics from the Top Down.

[Note: this is a slightly edited ChatGPT translation of an article for the Italian daily Domani]

Last week’s piece of news is the gap that opened between the US central bank, the Fed, and the European and British central banks. Apparently, the three institutions have adopted the same strategy, deciding to leave interest rates unchanged, in the face of falling inflation and a slowdown in the economy. But, for central banks, what you say is just as important as what you do; and while the Fed has announced that in the coming months (barring surprises, of course) it will begin to loosen the reins, reducing its interest rate, the Bank of England and the ECB have refused to announce cuts anytime soon.

To understand why the ECB remains hawkish, one can read  the interview with  the Financial Times  of the governor of the Central Bank of Belgium, Pierre Wunsch, one of the hardliners within the ECB Council. Wunsch argues that, while inflation data is good (it is also worth noting that, as many have been saying for months, inflation continues to fall faster than forecasters expect), wage dynamics are a cause for concern. In the Eurozone, in fact, these rose by 5.3% in the third quarter of 2023, the highest pace in the last ten years. The Belgian Governor mentions the risk that this increase in wages will weigh on the costs of companies, inducing them to raise prices and triggering further wage demands; As long as wage growth is not under control, Wunsch concludes, the brakes must be kept on. Once again, the restrictive stance is justified by the risk of a price-wage spiral, that so far never materialized, despite having been evoked by the partisans of rate increases since 2021. Those who, like Wunsch, fear the wage-price spiral, cite the experience of the 1970s, when the wage surge had effectively fueled progressively out-of-control inflation. The comparison seems apt at first glance, given that in both cases it was an external shock (energy) that triggered the price increase. But, in fact, it was not necessary to wait for inflation to fall to understand that the risk of a wage-price spiral was overestimated and used by many as an instrument. Compared to the 1970s, in fact, many things have changed. I talk about this in detail  in Oltre le Banche Centrali, recently published by Luiss University Press (in Italian): Automatic indexation mechanisms have been abolished, the bargaining power of trade unions has greatly diminished and, in general, the precarization of work has reduced the ability of workers to carry out their demands. For these and other reasons, the correlation between prices and wages has been greatly reduced over three decades.

But the 1970s are actually the exception, not the norm. A recent study by researchers at the International Monetary Fund looks at historical experience and shows that, in the past, inflationary flare-ups have generally been followed with a delay by wages. These tend to change more slowly than prices, so that an increase in inflation is not followed by an immediate adjustment in wages and initially there is a reduction in the real wage (the wage adjusted for the cost of living). When, in the medium term, wages finally catch up with prices, the real wage returns to the equilibrium level, aligned with productivity growth. If the same thing were to happen at this juncture, the IMF researchers believe, we should not only expect, but actually hope for nominal wage growth to continue to be strong for some time in the future, now that inflation has returned to reasonable levels: looking at the data published by Eurostat, we observe that for the eurozone, prices increased by 18.5% from the third quarter of 2020 to the third quarter of 2023,  while wage growth stopped at 10.5%. Real wages, therefore, the measure of purchasing power, fell by 8.2%. Italy stands out: it has seen a similar evolution of prices (+18.9%), but an almost stagnation of wages (+5.8%), with the result that purchasing power has collapsed by 13%.

Things are worse than these numbers show. First, for convergence to be considered accomplished, real wages will have to increase beyond the 2021 levels. In countries where productivity has grown in recent years, the new equilibrium level of real wages will be higher. Second, even when wages have realigned with productivity growth, there will remain a gap to fill. During the current transition period, when real wages are below the equilibrium level, workers are enduring a loss of income that will not be compensated for (unless the real wage grows more than productivity for some time). From this point of view, therefore, it is important not only that the gap between prices and wages is closed, but that this happens as quickly as possible.

In short, contrary to what many (more or less in good faith) claim, the fact that at the moment wages are growing more than prices is not the beginning of a dangerous wage-price spiral and the indicator of a return of inflation; rather, it is the foreseeable second phase of a process of rebalancing that, as the IMF researchers point out, is not only normal but also necessary.

The conclusion deserves to be emphasized as clearly as possible: if the ECB or national governments tried to limit wage growth with restrictive policies, they would not only act against the interests of those who paid the highest price for the inflationary shock. But, in a self-defeating way, they would prevent the adjustment from being completed and delay putting once and for all the inflationary shock behind us.

Fergus Cumming and Danny Walker

Bank Rate has risen by more than 5 percentage points in the UK over the past couple of years. This has led to much higher mortgage rates for many people. In this post we analyse another potential source of pressure on mortgagors: the potential for falls in house prices to push borrowers into higher – and therefore more expensive – loan to value (LTV) bands. In a scenario where house prices fall by 10% and high LTV spreads rise by 100 basis points, we estimate that an additional 350,000 mortgagors could be pushed above an LTV of 75%, which could increase their annual repayments by an extra £2,000 on average. This could have a material impact on the economy.

There is significant public and media attention on how the Bank of England’s interest rate decisions affect mortgagors. The interest rates set by central banks are of course a key determinant of the rates people pay on their mortgages. Banks tend to price mortgages off interest rate swaps, which reflect the market’s expectations of future policy rates. The relevant swap rates for the 80% of UK mortgages that have fixed interest rates are typically the two and five-year rates. While Bank Rate has risen by more than 5 percentage points since December 2021, the two-year swap rate has risen by 4.6 percentage points and two-year mortgage rates have risen by around 4.5 percentage points (Chart 1). But Bank Rate is not the only determinant of mortgage rates.

Chart 1: Mortgage rates have increased sharply in the UK – they tend to be priced off swap rates, which are linked to Bank Rate

Note: The chart shows quoted rates for two-year mortgages at different LTV ratio bands. It compares them to Bank Rate (the Bank of England policy rate) and the two-year swap rate, both of which are considered risk-free rates.

Source: Bank of England.

Mortgages with lower deposits – higher LTV ratios – have higher interest rates, but the spread is currently very low

Loosely speaking, a mortgage interest rate is made up of the risk-free rate – typically the relevant swap rate – and some compensation for risk, known as the spread. LTV ratios are the key determinant of spreads. For example, someone with a deposit of at least 25% of the value of the house at the point the mortgage is issued qualifies for a 75% LTV mortgage, which comes with a lower interest rate than if they only had a deposit worth 10% of the value. Mortgages with higher deposits, and therefore lower LTVs, are generally safer for banks because higher deposits means borrowers can withstand larger house price falls before falling into negative equity. Higher LTV mortgages tend to have higher interest rates for that reason.

Throughout the 2010s it was common for the spread between 90% and 75% LTV mortgage rates to be between 1 and 2 percentage points (Chart 1). As of August 2023, that spread was less than 0.4 percentage points. In fact, spreads have been very narrow since 2021 and the last time spreads were at today’s levels was probably in 2008, which is before the official data began. Given that high LTV mortgages look relatively cheap compared with recent history, we construct an illustrative scenario where the 90% LTV spread returns to close to its post-2010 average – something we regard as plausible.

We analyse an illustrative scenario where mortgage spreads rise by 100 basis points and house prices fall by 10% from their peak

Our aim is not to forecast what will happen in the mortgage market, but simply to examine a set of conditions that are within the realms of possibility. We use data on the universe of UK owner-occupier mortgages in the Product Sales Database. The most detailed information is recorded when mortgages are originated for the first time and upon remortgage. We build a snapshot of the mortgage market by modelling how much principal people have paid down since origination and how house prices have evolved in their region. We focus on mortgages originated since 2020 Q4 because they are most likely to have high LTV ratios, given the borrowers have not had much time to pay down principal and have had less time to benefit from significant house price increases.

In our scenario analysis, the 90% LTV mortgage rate increases by 100 basis points (Chart 2) and house prices fall by 10% (Chart 3). As a comparison, in the 2007 to 2009 financial crisis, the 90% LTV spread – measured versus 60% LTV mortgages – reached over 250 basis points and house prices fell by almost 20% from peak to trough.

Chart 2: In our scenario analysis, the interest rates on mortgages with LTV ratios of above 75% increase by 100 basis points, taking them closer to historical spreads

Note: The chart shows quoted rates for two-year mortgages at different LTV bands, expressed as a spread versus the 0%–60% LTV rate. We analyse an indicative scenario where the spread on 75%–90%, 90%–100% and 100%+ LTV mortgages rises by 100 basis points.

Source: Bank of England.

We recalculate LTVs following the 10% fall in house prices in the scenario and assume all mortgagors eventually have to refinance at the new higher rate for their LTV band. In the real world, mortgagors reaching the end of their fixed term will face a recalculation of their LTV based on a revaluation of their house, which is typically calculated using private sector indices. As it happens, those indices have already fallen by a few per cent more than the official price index shown on Chart 3. We do not model mortgage choice in the scenario: for simplicity we assume that mortgagors take out a two-year fixed-rate mortgage.

Chart 3: In our scenario analysis, UK average house prices fall by 10%, taking them back to around their 2021 level

Note: The chart shows the UK house price index expressed as a percentage change since the start of 2010. We analyse an indicative scenario where the index falls by 10%.

Sources: Bank of England and Office for National Statistics.

The scenario pushes an additional 350,000 mortgagors above 75% LTV, increasing their annual repayments by £2,000 on average

At origination, around 40% of recent mortgages had deposits that were too small to be eligible for a 0%–60% or 60%–75% LTV mortgage. When we take account of principal repayments and house price growth since origination, that suggests around a quarter of recent mortgages – just under 800,000 – are above that 75% LTV threshold now.

We find that the house price fall in our scenario pushes an additional 350,000 mortgagors above the 75% LTV threshold, taking the total back to around 40% of recent mortgagors (Chart 4), or 1.1 million. It also pushes around 3% into negative equity. The assumed 100 basis point increase in mortgage spreads in the scenario leads to an average increase in annual repayments for these mortgagors of just over £2,000 by the time they refinance, over and above the impact from the increase in swap-rates. That is clearly a material impact for the people affected, but is it material for the economy?

Chart 4: The scenario leads to a rise in LTV ratios for recent mortgagors, which comes with higher interest rates

Note: The chart shows all UK owner-occupier mortgages in the Product Sales Database originated since 2020 Q4, split by LTV ratio. We update the loan amount outstanding by modelling the scheduled flow of principal repayments for each loan. We update the house price based on an assumption that house prices have evolved in line with the average price in their region (eg London, South East of England etc). The scenario reduces prices uniformly by 10%. We assume for simplicity that there are no 80% LTV products. The numbers should be interpreted as indicative rather than a precise read on the stock of UK mortgages.

Sources: Bank of England and Financial Conduct Authority Product Sales Database.

The macro impact of this scenario could be material, given that it affects those mortgagors that are most financially constrained

At first glance, the impact of this scenario looks relatively modest in comparison to the increase in Bank Rate that has already occurred. The 100 basis point increase in mortgage spreads in our scenario is less than a quarter of the size of the rise in swap rates that has already occurred. It also only affects 40% of recent mortgagors, and just over 10% of all mortgagors. Focusing on recent mortgagors, our analysis suggests that their aggregate additional repayment burden (£2.4 billion) amounts to around 20% of the total repayment increase caused by the rise in Bank rate on its own (£11 billion).

But it is also true that the mortgagors impacted by this scenario are some of the most financially constrained households, and some of the most important for policymakers to consider. Well-established theoretical research has emphasised the role of heterogeneity in macroeconomics and empirical research has previously explored the importance of the most levered mortgagors in the transmission of monetary policy. To the extent that the scenario affects households most likely to substantially change their spending patterns, it is plausible that this amplification channel is not trivial. Indeed, for the most levered mortgagors, the scenario eventually increases repayments by 40% over-and-above the rise in mortgage rates already baked in.

Implications

Policymakers across the globe are well versed in the importance of the housing and mortgage markets, particularly for monetary policy transmission. The financial crisis is still in the rear-view mirror and much has been learned from it. But this post highlights an interesting channel of monetary policy which, while it will be captured implicitly in some models, is often less discussed outside policy circles. The scenario analysis reminds us that there can be more to monetary policy tightening than risk-free rates. Many people expect the tightening that has already occurred to lead to a significant fall in house prices, and it is plausible that mortgage spreads will return to historical levels. Although there is uncertainty, this has the potential to lead to a material impact on economic activity over and above the impact of risk-free rates.

Fergus Cumming is Deputy Chief Economist at the Foreign, Commonwealth and Development Office. He used to work on monetary policy and financial stability at the Bank. Danny Walker works in the Bank’s Deputy Governor’s office.

If you want to get in touch, please email us at bankunderground@bankofengland.co.uk or leave a comment below.

Comments will only appear once approved by a moderator, and are only published where a full name is supplied. Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.

In modern states, demand for currency comes from the ongoing self-imposed liability for the currency. There is no need to pay savers in order for them to desire to hold the currency (interest on sovereign bonds issued for “deficit spending”). Any justification for doing so must rest on some other perceived benefit of paying savers.

Internationally, besides forex speculation, the fundamental reason there is demand for a currency is because entities from outside of that currency area desire to purchase something from within it.

There is no reason for states to pay interest on the state’s currency in order to entice others’ demand for it unless an argument is made that increasing demand through paying holders of the currency beyond the desire to purchase goods within the area is somehow a useful and sustainable thing to do.

In both instances, this payment to holders of the currency is structured as interest payments.

Note that much of the complexity of financial practices, domestic and international, in some way or other is related to interest rates, directly and in the immensely complex financial instruments that build on the practice.

The web of production and distribution, regulation, infrastructure, and the politics inherent in these constitute an immensely complex system. Indeed, the primary “problem” for a people is to organize a social structure capable of governance – the attempt to minimize violence, maximize material wellbeing, in what is considered an efficient, just way. The monetary system a society creates is the primary organizing tool for achieving these ends.

The immense complexity within a state is increased greatly once again when many states with their monetary systems interact.

As noted, the additional layer of interest payments to savers of a currency is gratuitous as far as the domestic goal of demand for the currency and, at the international level, for there to be demand for a currency. There is no necessary reason to pay people to hold a currency to create demand in either case. Any decision to do so must be justified on some other clear benefit to society.

However, given that the unpredictable, often erratic nature of complex systems is already the greatest challenge facing a society, any additional layer of complexity that makes managing or understanding our social systems exponentially more difficult is detrimental.

Organization that increases productive capacity, fair distribution, gains from trade etc. are useful. Additional financial complexity beyond what facilitates these, however, is the attempt to gain on paper beyond what real resources and productive capacity can actually achieve. More importantly, in rendering an already hyper-complex system an order of magnitude more complex still, they decrease the potential for good governance.

The real-economy factors of technology, wage structures and – for FDI – quality of infrastructure, workforce, legal environment etc. are the targets that work and are improvable through good governance. An attempted financial fix to these that renders governance impossible is a huge step backwards. Paying savers of a currency is a vestigial practice that has no logic in modern monetary systems. The supposed benefits of doing so are assumed, with little evidence provided supporting them. The detrimental effect on good governance are plain to see yet seldom holistically examined.

A strange game.

The only winning move is not to play.